Insights: Possible Impact of the Union Budget on Arbitrage Funds

With the eagerly anticipated Union Budget on the horizon, market participants are abuzz with speculation regarding its potential ramifications. While the exact date remains undisclosed, projections suggest a likely unveiling around July 17, 2024, as per past precedents.

What is the speculation?

Speculation abounds, particularly relating to how changes in taxation might affect listed equity capital gains and its impact on arbitrage funds. Here’s a breakdown of the changes that could happen:

1. Tax rates on short-term holdings (currently at 15%) 
2. Tax rates on long-term holdings (currently at 10%)
3. Change of long-term holding periods (currently at 1 year)
4. Allowing grandfathering of existing investments
   
   

What are the most likely scenarios and how it impacts arbitrage funds?

Considering these factors, we explore the three most likely scenarios. It's important to note that numerous factors, including market levels, positioning of markets/managers, sentiments, global factors, opportunity cost etc. can influence outcomes. Our assessment reflects the current market landscape and will be refined closer to the event.

According to us, the change of holding periods may not significantly impact short-term investor decisions.

What is the worst-case impact of the event?

Most likely worst-case impact: As the equity arbitrage spreads widen from 7.5% to 10%^@ (a level that attracts other arbitragers seeking to capitalize on the opportunity), there could be a mark-to-market (MTM) impact on the funds. Our estimate suggests it could be to the extent of 2-3 bps^# absolute, considering the 8-day time to expiry, making the impact from spread widening manageable. However, investors who hold on until expiry may expect to recover the drawdown and potentially gain more.

Good to know worst-case impact: In the past 10 years, the worst day for arbitrage funds occurred on March 24, 2020, when one day returns were between -25bps to -33bps absolute^* (And two-day returns were between -38bps to -43bps). This was during the COVID-induced market disruption that led to wider spreads. However, within 2-3 days, the entire drawdown was recovered, demonstrating the resilience of arbitrage strategies.

(^@Survey of market participants, ^*Fund considered (Kotak Equity Arbitrage Fund, Invesco India Arbitrage Fund and SBI Arbitrage Opp Fund), ^#Avendus Internal Analysis)